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Using ETF’s as a hedge

Updated on July 24, 2016

Small investment hedges portfolio

Being a market timer, there are times in the stock market where I feel the market has topped and I would like to sell some of my mutual funds and buy them back at a later date when the market has dropped. There are problems with doing this. I like the funds I have! When investing outside of an IRA there are tax implications. Many times mutual funds require you to hold them for a number of months before selling them or you will have to pay a penalty. The question I ask is how may I get around this problem? The answer is in leveraged exchange traded funds.

To understand how this works one must understand that your portfolio is a single pool of money not some fragments invested here and there. You must also understand that your mutual fund prices will vary up and down at a rate similar to the market.

Increase your investments growth rate

Leveraged 2X short ETF’s

Leveraged short leveraged exchange traded funds increase in value at a rate double the percentage drop in the index the exchange traded fund is following. For example the NASDAQ 100 index leveraged exchange traded fund is symbol QID. A one percent drop in the NASDAQ will cause a two percent rise in the QID leveraged exchange traded fund. Like wise a five percent drop in the NASDAQ 100 will cause a ten percent rise in the fund.

So how do I make this work in my portfolio? Let’s assume I believe the stock market is going to pull back or drop. Let us assume that I have $80,000 in mutual funds and $20,000 in cash. At this point I go out and buy $20,000 in leveraged exchange traded fund QID. Next let us assume I was right and the market dropped 10 percent. My mutual funds would be worth only $72,000. My investment in QID would be worth $24,000 meaning I my portfolio would drop in total value to $96,000. If I had not purchased QID my portfolio would have dropped to $92,000.

Let’s assume I was wrong and the market goes up another 10 percent. My mutual funds rise in value to $88,000. My investment in QID drops 20 percent in value to $16,000. My portfolio has risen to $104,000. If I had not purchased QID my portfolio would have raised to $108,000.

What has happened is I have limited my losses (and also my gains). I have created the same effect as selling some of my mutual funds without having to sell them. To get the effect of a 10 percent drop in the example above I would have had to sell $40,000 worth of mutual funds or half of my holdings. This creates one taxable event. Even in the case of an IRA it means less trading which can cause a host of issues.

There are a host of leveraged exchange traded funds available to investors. They include:

QID- NASDAQ 100 2 times short

DXD- Dow 2 times short

SDS- S&P 500 2 times short

MZZ- S&P 400 2 times short

SDD- S&P 600 2 times short

TWM- Russell 2000 2 times short

There are other leveraged exchange traded funds available some of them go up 2 times the market or even 3 times the market but are not covered here.

Using this method you must accept that you may be right or you may be wrong. This is not something for novice investors to be doing with their nest egg.

Be sure to keep your portfolio well diversified and keep within your own asset allocation. Invest in the best funds in those asset classes. Once the investor has their asset allocation select the best small cap, large cap, global, bond, and even concentrated portfolio funds for their portfolio.

Fund picks for 2010 may provide you with some interesting reading.

Leveraged 3X short ETF’s

For those of you who may wish to use a 3X leveraged ETF's there are two that I recommend. TZA which goes up 3X the value of the Russel 3000 and SQQQ which is tied to the NASDAQ 100.


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    • Mitch King profile image

      Mitch King 8 years ago from Wilsoville, OR, USA

      This is some excellent advice in your hub. I try hard to keep my portfolio varied and take several approaches so that if one fails I do not lose it all.

    • DiamondRN profile image

      Bob Diamond RPh 8 years ago from Charlotte, NC USA

      I am using FAS for big banks, BGU for large caps, TNA for small caps and ERX for energy plays.

      None of these are going to tank because of management missteps or hanky panky by a CEO, etc.